Investors often last to see a fund’s portfolio moves

Where is the trading data going and how does it really gets used?

Mutual funds reveal their portfolios to shareholders every three months. Some willingly disclose it more often on the company website.

But more often than shareholders are likely to see what they own, the fund companies are likely to be giving the information to what might be considered “special friends.”

Patrick Samuels / Shutterstock.com

At a time when the leaking of proprietary information by even a few seconds has the potential to move markets, the uneven way that the mutual fund community disseminates its holdings has its own pitfalls. The fund industry is mostly ignoring the problem and—since it is impossible to quantify an impact on individual funds—shareholders are oblivious.

Yet funds have a Big Data problem, where huge amounts of information about what funds do is being collected, then used to learn things about manager activities that could not have been detected with smaller amounts of information or with less-sophisticated analytical methods.

A fund’s trading record is the intellectual property of the shareholders, but individual investors are pretty much the last ones to get access to that information.

For example, the American Funds recently changed its portfolio disclosure rules, a change that shareholders would only know about in the unlikely event they read the funds’ “statement of additional information.” Under the disclosure rules, the firm releases its portfolio quarterly, but then makes more frequent and regular disclosures to the fund’s “custodian, outside counsel, auditor, financial printers, proxy voting service providers, pricing information vendors, co-litigants (such as in connection with a bankruptcy proceeding related to a fund holding) and certain other third parties … each of which requires portfolio holdings information for legitimate business and fund oversight purposes.”

The change made this month simply added to the list of who is eligible to get the information more frequently than shareholders, but the long list of recipients of the data is common in the fund industry. More than half of all funds disclose their portfolios more regularly than required by the Securities and Exchange Commission, often to appease big institutions, pension funds and others with large positions.

The recipients of the extra portfolio releases all get the details—with active transaction trends redacted by management—under agreements that prohibit them from sharing it with others, profiting from the data, or, typically, for using it in any way outside of researching the fund and evaluating its activities. [Some firms post their portfolio updates online, giving individual shareholders access to the information at the same time as the other interested parties.]

The question is where that extra information goes and how it really gets used.

While managers worry about front-running—where released information lets traders get a jump on the fund and profit from being ahead of the fund’s moves—data leakage can be used in many ways.

Don Phillips, head of research for Morningstar Inc., noted that advisors and others demand more regular portfolio disclosures, and said that the more regularly portfolios are released, the better shareholders can be served by analysts. He compared it to drug testing, where more frequent tests don’t guarantee that cheaters will be caught “but you have more ability to make sure a fund is not juicing the portfolio, taking big, inappropriate bets between reporting periods, then beating the competition and saying ‘look at how good we are at this.’”

But Phillips—pointing to the fact that products like Morningstar’s “Full Holdings Data for Institutional Investors” have gotten virtually no pick-up from the hedge-fund world—also called talk of reverse-engineering portfolio data “one of these urban legends in the fund industry. I don’t think there is any real evidence that it exists and that people are doing it.”

But there is evidence. At its most simplistic, you can surmise that one reason why institutional investors started “dark pools”—where trading volume or liquidity is not available to the public—is that they knew transaction data was being used against them.

C. Thomas Howard, director of research at AthenaInvest, considers a fund’s portfolio “trade secrets,” and makes no bones about “mining [funds’] intellectual capital, noting that his research has shown that holdings information “is valuable up to a year after the fact.”

The investment philosophy of Athena’s Global Tactical ETFs involves the use of “patented behavioral research to measure equity manager and investor behavior to determine the most attractive markets and capitalization ranges in which to invest on a global, tactically unconstrained basis. Our research produces signals which are unique behavioral indicators that we believe are superior to momentum or market valuation techniques in predicting future performance.”

In short, the firm buys portfolio holdings data, uses it to see what managers are doing, and then tries to ride the crest of waves they create.

That’s one simple example; there are many others. Fund companies are also concerned with how custodians and clearinghouses may be using transaction/portfolio data.

Said Howard: “Our methodology is unique to us, but I’m sure there are plenty of others looking at whatever data they can get on funds and trying to see what they can make of it.”

Next week: Is it too late to change/standardize portfolio disclosure rules?

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